Bank of China Limited : Xiao Gang: Renminbi's global use growing

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Internationalization of China's currency is inevitable
and it should prepare for the systematic financial risks that
will arise

Just a few years ago, it would have been difficult to imagine
that the global use of the renminbi would spread so fast.
However, today we can see the situation has changed greatly.

In 2011, China and its trade partners conducted cross-border
renminbi trade settlements valued at 2.58 trillion yuan ($410
billion), more than 4 times the 2010 total, and covering
nearly 10 percent of the China's total trade.

Meanwhile, renminbi-denominated overseas and foreign direct
investment - a pilot program which began in 2011 - reached
110 billion yuan. So far, China's central bank has signed
bilateral currency swap agreements valued at 1.6 trillion
yuan with 16 of its counterparts around the world.

Although status as a major global reserve currency is closely
associated with full capital account convertibility, a
flexible currency regime, deep and liquid capital markets and
a willingness to let other countries accumulate the currency,
through running trade deficits, it should be remembered that
the renminbi still has many opportunities to internationalize
further before these conditions are met. In fact, the
currency's ascendancy and progress toward these
conditions can occur simultaneously.

Historically, the internationalization of a sovereign
currency is determined by the size of its economy and trade.
The United States' economy surpassed the United
Kingdom's around the time of the World War I, and the
latter lost its status as the world's largest exporter in
the 1920s. Finally, the US dollar displaced Sterling as the
major global reserve currency around World War II.

As the world's second largest economy, the largest
exporter and the second largest importer, China has become
increasingly integrated into the world economy, and this has
been one of the main driving forces toward the renminbi's
global usage. Moreover, China is one of the largest
destinations for foreign direct investment, $1.22 trillion
from 1978 to 2011.

A fully convertible currency does not equal an international
reserve currency. Nowadays, around 100 countries maintain
fully convertible currencies, but only a few are used as
global reserves. That is to say, the internationalization of
a currency can proceed before its capital account is
liberalized. It was under such conditions of inconvertibility
that the German and Japanese currencies internationalized. A
current account surplus should not be a barrier to the path
of forging an international currency. The UK, the US, Germany
and Japan all internationalized their currencies whilst
running trade surpluses. The most important channel for
currency outflow was overseas capital investment, in
particular, letting credit follow trade outside the countries
and have a capital account deficit.

Despite its overall long-term net trade surplus, China runs
bilateral deficits with many Asian countries, therefore,
there is large potential for wider use of the renminbi. On
the other hand, as more and more Chinese enterprises go
abroad, China has accelerated its overseas direct investment,
totaling $437.3 billion in 178 countries and regions by the
end of 2011. The International Monetary Fund forecasts that
China's yearly ODI will exceed $280 billion by 2016.

That is a comprehensive way for China to internationalize the
renminbi: combining trade settlement, overseas investment and
foreign aid.

If the renminbi wants to become a global reserve currency,
China's financial markets would need to open further to
foreign investors, which would require the removal of
restrictions on cross-border capital flows. However, China
can make full use of the Hong Kong Special Administrative
Region, an international financial center, as a springboard
to internationalize its currency while taking gradual steps
to reform mainland markets.

Hong Kong's offshore renminbi market has already played
and will continue to play an essential role in cross-border
renminbi investments and other financial products and
services. At present, renminbi deposits amount to 10 percent
of total banking deposits in Hong Kong, and the renminbi has
become the third largest currency held after the HK dollar
and US dollar.

Interestingly, the UK signed a deal with Hong Kong aimed at
turning the City of London into an offshore trading center
for the renminbi. Singapore has also showed strong interest
in this regard. Whether trade in the offshore renminbi has
boomed or not, many international banks, such as Deutsche
Bank, CitiBank and HSBC already have renminbi traders sitting
on their dealing rooms in London.

Fundamentally, status as a global currency must be driven by
market forces. The cross-border renminbi business provides
enterprises and financial institutions with the right to
freely choose settlement and investment currency, so it helps
them get rid of the dependence on only one or two currencies,
mitigating the exchange rate risks, saving costs and
increasing efficiencies. It is estimated that renminbi
settlement reduces the transaction cost by about 2 percentage
points in contrast to settlement in US dollar.

More importantly, there will be a new choice for enterprises
to raise funds from different onshore and offshore renminbi
markets, lowering the cost of financing and conversion.

In January, a survey on 200 overseas customers conducted by
the Bank of China found that 67 percent of respondents have
used or plan to use the renminbi in their business
operations, indicating the huge demand of cross-border
renminbi markets.

In practical terms, remninbi-denominated assets are becoming
attractive products for investors. Japan and the Republic of
Korea announced their plans to buy Chinese government bonds.
China has been asked to extend renminbi-denominated loans to
BRICS group and other countries. That could be a further step
to expand the use of the renminbi in international
transactions, and would be effective way of gradual
internationalization of the renminbi.

It will encourage non-residents to hold renminbi when the
currency has potential for appreciation. After years of
unilateral appreciation, the renminbi exchange rate is now
close to equilibrium, making the currency more likely to
experience a two-way fluctuation. But that does not
necessarily mean an end to renminbi appreciation. Apparently,
it is significant to intensify the currency regime reform and
maintain its relative stability at the reasonable level.

Every silver lining has its cloud. With the renminbi's
internationalization, China should be well prepared to
address new challenges; the systemic financial risks that can
be generated hand-in-hand with free cross-border capital
flows and financial reforms.

While the renminbi's internationalization has a long way
to go, it is inevitable, and will be sooner rather than
later. It may not displace the US dollar, but can add a new
alternative to the multilateral international monetary
system.